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Rising rates pose new challenge for investors

With the Federal Reserve about ushering in a new era of rising interest rates, a prudent investor might use the occasion to re-examine portfolios, strategies and risks.
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Federal Reserve Chairman Alan Greenspan made it official Wednesday, but the economy already had passed a major turning point. Long-term interest rates have been rising for months and probably hit bottom last year after a steady decline that lasted 20 years. Consumer inflation likewise has been accelerating after hitting its lowest level in nearly 40 years. How should investors respond to this sea change in financial conditions?

To be sure, there is no need to panic. Interest rates and inflation are still low by historical standards, and the economy seems poised for steady growth well into 2005. But the Fed passed a milestone Wednesday by raising the benchmark overnight lending rate from a 46-year low of 1 percent. And that is just the beginning: The central bank probably will continue tightening credit well into next year to keep a lid on inflation.

A prudent investor might use this shift in monetary policy as an occasion to re-examine portfolios, strategies and risks.

Experts agree a rising-rate environment can be fraught with risks, for stocks as well as bonds.

On the bond side, the risks are fairly straightforward. As interest rates rise, the value of existing bonds declines because they carry the older, lower rates of return.  The longer the bond’s duration, the higher the risk.

Because long-term interest rates already have risen in response to the improving economy and rising inflation, bond prices have fallen sharply. Long-term government bond funds, for example, have lost 6.5 percent of their value over the past three months, according to Morningstar.

On the stock side, the story is more complex. As interest rates rise, bonds become a more attractive investment option, particularly for investors who plan to hold the bonds until maturity. The increased competition for investment dollars can pressure stock prices. Higher interest rates also hurt stocks in other ways. For example they raise the cost of doing business, squeezing corporate profit margins.

Given that both stocks and bonds face added risks, it is hardly surprising that experts disagree on how to respond.

Standard & Poor’s recommended in mid-June that investors reduce their exposure to the stock market during this time of transition, even though the company’s top strategists still believe the S&P 500 will gain another 6 percent between now and the end of the year. The company’s recommended asset allocation mix is now 60 percent stocks, 30 percent cash and 10 percent bonds, down from 70-20-10.

Other strategists take the opposite approach. T. Rowe Price shifted 5 percent of assets from bonds to stocks for its asset allocation funds, although it completed the shift in March 2003, said Ned Notzon, president of the brokerage’s Spectrum Funds.

Hugh Johnson, chief investment officer for First Albany Capital, recommends that investors load up on just about as much stock as they can stomach. For investors who prefer to have between 60 and 90 percent of their funds invested in stocks, for example, he currently recommends an 85 percent allocation.

“The bull market (in stocks) is not over,” he said. “The bull market may be uninspiring, but it is going to continue.”

Johnson said he sees no sign that inflation is heading high enough to threaten the economy or the stock market. Given a growing economy with modest inflation, stocks should continue their historical pattern of outperforming bonds over the long run, he said.

“The only reason investors don’t buy all stocks is they can’t stand the volatility — and I don’t blame them,” he said. “You’ve got to find the right mix that helps you both beat inflation and lets you sleep at night.”

Here are some other tips for dealing with the twin threats of rising interest rates and rising inflation:

1. Stick with your plan. If you’re generally comfortable with 60 percent of your money in stocks and 30 percent in bonds, don’t dump everything into the stock market because you’re worried about rising interest rates. There is no way of predicting how fast and how far rates will rise. The best strategy for most people is to periodically rebalance their portfolio to stay within predetermined ranges. At the most, you might shift 5 percent one way or the other if you feel nervous about rising rates — not 30 percent, said Notzon of T. Rowe Price.

2. Beware of long-term bonds. Unless you are a professional investor or a real high roller, you probably should steer clear of long-term bonds, said Steve Lugar, managing director of BHCO Capital Management in Dallas, Texas. Bonds that mature in 10 years or more become particularly risky in a rising-rate environment. He suggests investors stick with bonds that mature in five years or less — and even then only buying them through mutual funds. Investors have enough exposure to risk in the stock market, he reasons. They buy bonds for their relative safety.

3. Do not try to time the market. Certain sectors of the stock market, such as the financial industry and home builders, are considered more vulnerable to rising interest rates. Other sectors, like retailers, are supposed to be more protected. But financial stocks already have been hammered in recent months, meaning most of the coming rate hikes may be built into the stock market. Again, the best strategy is to have a predetermined allocation and then periodically rebalance.

4. Consider locking in a mortgage rate. Over the past several years, dirt-cheap adjustable-rate mortgages have been hugely popular. But they could become a burden in coming years as interest rates head higher. For homeowners who plan to stay in their current home at least several years, it might be time to consider locking in a rate rather than stick with an ARM that could move upward every year, or even more often.

5. Eliminate high-interest debt. This is one of the few moves that pays off at any point in the economic cycle, says Lugar. Consumers who are paying 12 to 18 percent — or more — on credit card debt could save hundreds or thousands of dollars a year by paying it off. This should be the first step in any financial plan, according to many experts. For homeowners, it is not too late to cut debt payments by taking out a home-equity loan and using the proceeds to pay off higher-rate revolving loan balances.